By Harrison Heaton
Formulating a clear message early, keeping the guarantees you make, and doing so consistently is the perfect recipe to be successful in any aspect within life. This is no different from what makes hedge funds successful. As we know hedge funds pool large amounts of capital from institutional investors or individuals and employ complex strategies of portfolio generating and risk management to receive great returns for those clients.
Now, the hedge Fund industry is an extremely lucrative industry that needs to stay ahead of the curve in order to continue their success, but at the same time it is a massive roller coaster that fluctuates up and down due to the players within it I.E the investors. Within the 2018 fiscal year, investors had a combination of nervousness around market conditions, poor hedge fund performance and high fees which made them withdraw about $88 billion dollars nationwide, and almost 400 hedge funds were liquified, meaning all their assets were converted to cash on hand. Despite all this uncertainty, they still had about $3.2 trillion under their management. As we can see in the graphical depiction below, hedge fund launches and new establishments show a steady decline since the 2005 spike which verifies the information above, and we can see that liquidation has also been on the slight increase. Which again fits with the information above.
Yet, when it comes to success in the hedge fund industry, there are multiple concepts that lead to success. The first concept that hedge funds need to execute is competitive advantage. Competitive advantage is a very broad umbrella that encompases information advantage, marketing advantage, resource advantage, etc. High net worth individuals within your network, more advanced advertising, higher advanced technology, all fit like pieces in a puzzle for the success of hedge funds.This fits right into another huge factor that contributes massively to the advances of hedge funds is the confidence of investors through a well thought out and clearly defined investment strategy. If a hedge fund strategy is not profitable, repeatable, risk managed, and backed through a reputation, investors are very unlikely to put their hard earned capital into something of this caliber. When investment strategies have not been put to the crash test or tested in the waters of the market, there is not a lot of weight when it comes to hedge fund promises and words.
One of the most important aspects and underlying premise a hedge fund needs is a well funded and established seed of capital. As times evolve and foundational costs increase, the ability to establish a reputable hedge fund becomes less and less. Hedge funds require a new minimum amount of capital or commitments when compared to hedge funds launched earlier. Seed funds needed to enact a majority of new establishments are well over 100 million or more underneath their management to even be considered on the radar for big institutional allocators. Now, smaller hedge funds have the ability to do well, but if we are strictly talking about what makes a hedge fund successful to the point of financial security, more capital equals greater business. Yet without risk management it's easy to lose this business.
Hedge funds have a lot of tools at their disposal to risk manage, which is an absolute necessity when it comes to investing within the market. Managing business and an investment portfolio is not the easiest thing in the world. Long term and consistent growth applies a plethora of risk and hedge funds usually involve leverage, acquiring debt, derivatives, and complex timing in the market to provide the safety net investors look for. The hidden character within the hedge fund industry are consulting firms. Besides the primary risk management protocols that hedge funds incorporate themselves, these consulting firms' sole purpose for existence is to guide and manage firms to lower unnecessary risk.
A well regulated legal counsel and avoidance of pitfalls is the name of the game when it comes to the sensitive topic of utilizing other people’s money. An amazing sign for investors is the application of a great legal team which shows investors and competitors in the industry you're in it for the long haul and have optimism for the fund. Alongside this, picking a prime brokerage is a huge factor to success. Partners in business can either exponentially boost quality and success within a company, or deflate a company and all that their reputation stands for. How hedge funds trade and operate alongside weighing the benefit as opposed to the cost to maximize return is vital and a reputable, knowledgeable broker could take hedge funds a long way.
Specific trading tactics within hedge funds are the hammer to a builder. These tactics are what get a higher than average return. Furthering this idea, merger arbitrage, market neutral, long/short equity, quantitative analysis, etc. give hedge funds the ability to make investors above average return and therefore allowing the hedge to continue business and put food on the table. Long-Short equity accounts for approximately 40% of all the industries assets and refers to taking long positions on underpriced positions and shorting stocks that are expected to decrease in the near future. We can see this outperforms both hedge funds and the S&P 500.
This article is very informative and professional. You talk about hedge funds and their need to have competitive advantage. How would one hedge fund distinguish themselves from the rest?
I really enjoyed all of the background information on hedge funds which led into the specific strategies that these funds use to beat the market. Very interesting that the long-short method outperformed even general hedge funds, but nearly mirrored its movement.
Interesting article. I wonder how hedge fund returns compare to low-cost ETFs returns after fees/expenses. I also would be curious to know what goes into a 'prime brokerage'. I like that you highlighted that funds require a new minimum amount of capital when compared to hedge funds launched earlier.